Your portfolio wasn’t the only thing inverting today. The U.S. Treasury yield curve inversion deepened as the bond market prices in higher short-term prices and weaker long-term growth.
We’ll read the “tea leaves” of the bond market in a second, but first, let’s talk about June’s Consumer Price Index (CPI) report from the BLS.
The headline number accelerated to 9.1% YoY, above expectations of 8.8%, and the highest reading since 1981.
Higher energy and food prices drove the increase.
Meanwhile, the core CPI reading, which excludes energy and food prices because of their volatility, decelerated for the third straight month to 5.9% YoY.
This reading jives with the Federal Reserve’s preferred inflation metric, the core Personal Consumption Expenditures (PCE) index, which has been decelerating since March.
Essentially these two data points show us that the economic factors impacted by the Fed’s tightening policy are falling while things it has little control over, like food and energy prices, continue to soar.
However, an important point to remember is that these inflation readings are a lagging indicator. The CRB Index, a broad measure of commodity prices, has fallen roughly 16% since early June, and several individual commodities have dropped a lot more than that.
And if commodity prices stay at or below current levels, the next headline inflation number will likely be lower than June’s.
The counterargument is that commodities and prices of other goods included in the inflation measures are coming down because of recession fears, which there is some evidence of.
As we said at the top of the article, today’s bond market reaction tells us all you need to know about where its expectations stand.
The chart below shows the difference between the ten and two-year Treasury yields. Since the curve is inverted (below 0%), short-term rates are higher than long-term rates.
In English, this means that the bond market expects higher inflation (aka economic growth) over the next two years than it does over the next ten. We can identify that because the inversion was driven by the 2-year yield rising and the 10-year yield falling.
Additionally, the CME’s FedWatch Tool shows that the market has fully priced in a 75bps hike at the Fed’s July meeting and is now pricing the odds of a 100bp hike at 78%.
That would be an aggressive move, but the Fed has told us they’re not going to stop tightening until prices come down. And they’re not (at least not quickly enough).
Canada’s central bank hiked 100bps today, so a move like that in the U.S. would not be unprecedented, especially given the global environment.
In the end, the bond market isn’t always correct with its forecasts, but it has been well ahead of the Fed in the current cycle.
And for now, as long as inflation readings stay high and the labor market remains strong, it’s expecting the Fed to continue hiking aggressively.
Whether or not that will push the economy into a recession remains debatable, but today’s move in the yield curve suggests a recession is looking more and more likely. Plus, more and more Wall Street firms are beginning to take that view.
The TLDR version is:
- Headline inflation numbers hit a new record, driven by energy and food prices;
- The 10-2 year curve inverted as the bond market forecasts higher short-term prices/growth than long-term; and
- High inflation means the Fed will continue hiking aggressively, which many believe will push the economy into recession.
